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Do You Like Terra Firma Capital Corporation (CVE:TII) At This P/E Ratio?

Simply Wall St

Terra Firma Capital (CVE:TII) shares have retraced a considerable in the last month. But plenty of shareholders will still be smiling, given that the stock is up 9.0% over the last quarter. Indeed, the recent drop has reduced the annual gain to a relatively sedate 5.5% over the last twelve months.

All else being equal, a sharp share price increase should make a stock less attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). The implication here is that deep value investors might steer clear when expectations of a company are too high. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.

See our latest analysis for Terra Firma Capital

Does Terra Firma Capital Have A Relatively High Or Low P/E For Its Industry?

We can tell from its P/E ratio of 6.27 that sentiment around Terra Firma Capital isn't particularly high. The image below shows that Terra Firma Capital has a lower P/E than the average (13.0) P/E for companies in the mortgage industry.

TSXV:TII Price Estimation Relative to Market, February 7th 2020

Its relatively low P/E ratio indicates that Terra Firma Capital shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.

Terra Firma Capital's 346% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Even better, EPS is up 22% per year over three years. So you might say it really deserves to have an above-average P/E ratio. Unfortunately, earnings per share are down 3.8% a year, over 5 years.

Remember: P/E Ratios Don't Consider The Balance Sheet

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

How Does Terra Firma Capital's Debt Impact Its P/E Ratio?

Terra Firma Capital's net debt is considerable, at 386% of its market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.

The Bottom Line On Terra Firma Capital's P/E Ratio

Terra Firma Capital trades on a P/E ratio of 6.3, which is below the CA market average of 15.8. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue. Given Terra Firma Capital's P/E ratio has declined from 6.3 to 6.3 in the last month, we know for sure that the market is more worried about the business today, than it was back then. For those who prefer invest in growth, this stock apparently offers limited promise, but the deep value investors may find the pessimism around this stock enticing.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.